Insurance techniques help multifamily property owners maximize value.
Every multifamily property owner understands that many factors affect a property’s ability to turn a profit. They also understand that the real estate business is driven by net operating income. But not all owners may realize that a variety of insurance techniques can decrease premiums, which, in turn, boosts a property’s NOI, resulting in an increase in the asset’s value.
Understanding the basics of insuring multifamily properties is the first step to reducing premiums. Insuring apartments is different from insuring other commercial real estate properties. Because of the unique characteristics and inherent risks associated with apartments — specifically how they are built, location, occupancy, loss history, and age — far fewer insurance carriers are willing to offer property and liability insurance to the multifamily industry than to the retail, office, or industrial sectors.
Three main coverage areas generally drive insurance costs: property, general liability, and umbrella or excess liability. Property insurance provides coverage for damage caused by direct losses, such as fires, hurricanes, and earthquakes, among others. Generally, property insurance costs dominate apartment owners’ insurance budgets since the premiums are rated per $100 of value insured.
General liability and excess liability insurance are third-party coverage and protect property owners from lawsuits. Apartment owners have three major exposures to protect: trip/fall, assault/battery/sexual abuse, and punitive damages in states where recognized. Pricing is rated on a per-unit basis as opposed to square footage. Other types of liability insurance relative to property owners include professional (errors or omissions and directors and officers), workers’ compensation, hired/non-owned auto, and employment practices liability among others.
Lenders generally dictate the minimum amount of insurance required on properties that carry debt. There is a fine line that allows protection for lenders and owners without over-insuring. The following strategies may offset or reduce unnecessary insurance expenses in certain situations.
Planning the insurance six months to a year in advance of disposing of an asset could add significant dollars to the bottom line. For example, a 300-unit property located in Dallas was insured at $200 per unit with a $10,000 deductible. The owner wanted to trade out of the property and was advised to raise the deductible to $25,000, which resulted in a 9 percent savings on the premium. While the $5,400 in savings is not to be minimized, the real impact is to the NOI, which at a 7 percent capitalization rate provided $77,000 in value immediately.
This tool works well with catastrophe-exposed properties, as lenders are more lenient with those deductibles. However, owners must be comfortable with the risk associated with a higher deductible.
Another critical component of insuring apartments is proper valuation. There is a big difference between market value that lenders use versus the replacement cost carriers use. Fundamentally, a property insurance policy is intended to make an insured whole and will not act as a profit center. Knowing this, a savvy owner should take a hard look at the insurable values to keep those consistent with replacement costs, since property premiums are determined by the values insured.
Over-insurance is a common mistake with both lenders and insurance brokers who do not specialize in real estate. For example, last summer a client was buying a 400-unit complex in Hawaii, built in 1965. The lender required that the building values be insured for the full loan value, which was approximately $150 per square foot for frame construction. The lender did not give any consideration to the value of the land, which in Hawaii, is a large percentage of asset value.
Building cost data showed replacement costs at around $80 psf; with this information, the owner and lender were educated about the nuances of the property relative to the coverage, and the lender understood that the property was grossly over-insured using its numbers. This effort resulted in an $86,000 savings in property premium, which at a 7 percent cap rate equals $1.2 million.
When dealing with a portfolio of properties, greater opportunities exist to add value through purchasing insurance as carriers do when they purchase insurance on their portfolios. For instance, an owner has a $500 million portfolio with properties on the West Coast, in Texas, and in the Southeast. The highest-valued property does not exceed $30 million, but $50 million of the portfolio properties are on the West Coast, adjacent to one another.
A carrier insuring this portfolio will purchase insurance on the back end (re-insurance) at some level. To help determine its level of risk, the carrier models these locations against the pertinent exposures, such as earthquakes or fires. Using this example, the probable maximum loss reveals a potential loss that is a fraction of the total value.
The aggregation of values across a broad geographic area is what makes a program work. Realizing that a single occurrence cannot affect a location in Houston, Los Angeles, and Orlando, Fla., it actuarially allows for a lower insurance limit due to the unlikelihood of a single occurrence taking out all of the insured values across a large geographic region.
In this scenario, it does not make sense to purchase $500 million in coverage. Specifically, $50 million is at risk in the event of a total loss, so the insured may want to carry $100 million in a per occurrence limit to provide a bit of a buffer. The loss limit will provide a savings and during a hard market, such as in 2006, when it would have equaled a $100,000 to $200,000 premium savings, or $1.4 million to $2.8 million in value.
Another component of purchasing insurance that often is overlooked is timing. By understanding the market and how insurance is priced, there can be opportunities to take advantage of aggressive markets. For example, near the end of last year, a client with a $1 billion portfolio was advised that it would make sense to take advantage of market dynamics with a particular carrier that was looking to write deals before year-end as it had not filled its premium quotas. This opportunistic cancel/rewrite strategy resulted in an immediate net savings of $500,000 in premiums or $7.1 million in value at a 7 percent cap rate. Focusing on the multifamily insurance markets on a daily basis is the only way to know that a market has an appetite for a particular asset type.
While every dollar saved on insurance costs is an NOI dollar that can find its way back into a property’s bottom line, multifamily owners should remember that a low premium does not necessarily equal a good deal. Many policies sold on price alone contain several traps that can leave apartment owners in serious trouble. Policies that have a co-insurance provision typically are less expensive, but for good reason: The insured potentially can share in the loss. A good example of this is a commercial general liability policy with an assault-and-battery exclusion, which is not the kind of exposure an apartment owner can afford to leave uninsured. Additionally, policies that are based on actual cash value are less expensive, but much less valuable in the event of a loss.